1 October 14, 2009October 14, 2009

The Credit Crisis Continues…

Marshall BennettJames A. Harrod

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Credit Crisis Continues…Credit Crisis Continues…

Overview– Effects: what characterized the

crisis? What Happened? Some of the Causes What happened with the Credit

Rating Agencies? Conclusions

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Credit Crisis - Effects Credit Crisis - Effects - S&P 500 - 50% decline from January 2007 – March 2009- U.S. DB public pension funds – equity losses total ~$1 trillion*

* IMF Working Paper, How the Financial Crisis Affects Pensions – July 2009

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20 % decline in US Home Prices

Credit Crisis - Effects Credit Crisis - Effects

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massive increase in mortgage delinquencies

Source: The Wall Street Journal

Credit Crisis - Effects Credit Crisis - Effects

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massive declines in mortgage securities

Credit Crisis - Effects Credit Crisis - Effects

Source: CNNMoney/Markit Group

ABX-HE-A 07-2 tracks BBB-rated MBS issued in the first half of 2007.

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Government Intervention – Alphabet Soup

Government Intervention – Alphabet Soup

TARP – Troubled Asset Relief Program TALF – Term Asset-backed Securities Loan

Facility PPIP – Public-Private Investment Program MHAP – Making Home Affordable Program

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Structured Finance ProductsStructured Finance Products

Products created by Wall Street

Assets packaged into securities for sale to investors– Create a more liquid market for the asset– Allow financial institutions to deploy capital repeatedly

More alphabet soup:

– MBS/CMOs (mortgage backed securities/collateralized mortgage obligations)

– ABS (asset backed securities)

– CDOs (collateralized debt obligations)

– CLOs (collateralized loan obligations)

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Securitization ProcessSecuritization Process

Senior tranches

Subordinated tranches

SPV

MBS

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Credit Crisis – First SignsCredit Crisis – First Signs Mortgage Default Rates Increase – Q1 2007

– Adjustable Rate Mortgage Resets– Lower lending standards – riskier borrowers

Significant declines in ABX and related indices Secondary markets for structured products

experience liquidity problems Securitization becomes more difficult

Monoline insurers experience capital shortages– MBIA/AMBAC

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Problems at Mortgage Companies Problems at Mortgage Companies

Mortgage Companies Experience Problems:

– New Century

– Countrywide

– Northern Rock/UK

– Indymac

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Instability in Financial ServicesInstability in Financial Services

Major Commercial/Investment Banks

– Bear Stearns

– Lehman Brothers

– Merrill Lynch

– Wachovia

– Washington Mutual/WaMu

– Royal Bank of Scotland

– Citigroup

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Crisis Effects – Beyond the Big BanksCrisis Effects – Beyond the Big Banks

FDIC has seized/closed 127 institutions since 2007

AIG – problems with derivatives

December 2008 - Bernard Madoff - $64 billion Ponzi scheme

Massive government support to General Motors & Chrysler

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Financial Crisis – Some FactorsFinancial Crisis – Some Factors

Failure of the traditional gatekeepers– SEC – Madoff report points to failures– Banks – loans sold to investors– Rating Agencies – conflicts and failures

Proliferation of Structured Finance products

Opaque derivative markets (CDSs)– Warren Buffet:

“financial weapons of mass destruction”

Increased Leverage

Consumers’ high appetite for debt

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Rating AgenciesRating Agencies

Moody’s Investors Service, Inc.

Standard & Poor’s Ratings (owned by McGraw-Hill, Inc.)

Fitch Ratings Service (owned by Fimalac, S.A.)

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Rating Agencies’ RoleRating Agencies’ Role Called Nationally Recognized Statistical Rating

Organizations (NRSROs) by the SEC:– “official arbiters of financial soundness.”*

Many investors have guidelines or requirements that permit investments only in “investment grade debt”:– Moody’s: Aaa, Aa, A, Baa – S & P/Fitch: AAA, AA, A, BBB

Effective marketing of securities requires rating by an NRSRO

Ratings particularly important in “alphabet soup” financial products– Capital structure relies on subordination and

diversification

*James Surowiecki, “Ratings Downgrade,” The New Yorker – Sept. 28, 2009

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“Aaa” – More Risk Than

Expected

“Aaa” – More Risk Than

Expected

“AAA” – risk free?– Like a U.S. Treasury bond

Bonds were purchased based on rating and yield

Decline in value of “AAA” securities has affected institutional investors– Performed much worse than expected

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Rating Agencies – How did they get it

wrong?

Rating Agencies – How did they get it

wrong?

Outdated models

Structural conflicts of interest

Exemption from liability

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Outdated ModelsOutdated Models

Moody's rated three-quarters of this C.D.O.'s bonds triple-A. The ratings were derived using a mathematical construct known as a Monte Carlo simulation -- as if each of the underlying bonds would perform like cards drawn at random from a deck of mortgage bonds in the past. There were two problems with this approach. First, the bonds weren't like those in the past; the mortgage market had changed. As Mark Adelson, a former managing director in Moody's structured-finance division, remarks, it was ''like observing 100 years of weather in Antarctica to forecast the weather in Hawaii.'' And second, the bonds weren't random. Moody's had underestimated the extent to which underwriting standards had weakened everywhere. When one mortgage bond failed, the odds were that others would, too.

Moody's estimated that this C.D.O. could potentially incur losses of 2 percent. It has since revised its estimate to 27 percent.

The New York Times, Triple-A Failure, April 27, 2008

The rating agencies used statistical models that relied on historical default rates but the mortgages and underwriting standards had drastically changed and they failed to update their models to reflect this:

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Outdated ModelsOutdated Models

In Congressional testimony, Frank Raiter, former Managing Director and Head of Residential Mortgage Backed Securities Ratings at S&P, acknowledged that S&P had a new model to use, but did not use it.

The failure to use a new model was disastrous:

– Had these models been implemented we would have had an earlier warning about the performance of many of the new products that subsequently lead to such substantial losses. That … could have thus caused some of these products to be withdrawn from the market…

– An unfortunate consequence of continuing to use out- dated versions of the rating model was the failure to capture changes in performance of the new non-prime products. . . This, in turn, generated the unprecedented number of AAA downgrades and subsequent collapse of prices in the RMBS market.

October 22, 2008, Congressional Hearing testimony

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Rating Agency – ConflictsRating Agency – Conflicts

The credit rating agencies, which until late September 2007 were not regulated by statute, notoriously gave AAA ratings to these structured mortgage-backed securities. But that was not all: the ratings agencies sometimes helped to design these securities so they could qualify for higher ratings.

SEC Chairman Christopher Cox - Congressional Testimony, October 22, 2008.

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Rating Agency – Conflicts Rating Agency – Conflicts

Provided models to the arrangers:– Ratings-agency officials concede that they work

with Wall Street banks, even if they don’t exactly shout it from the rooftops. “You start with a rating and build a deal around a rating,” explains Brian Clarkson, Moody’s co-COO.

Portfolio, Overrated, September 2007. Providing the models to the banks allowed them to

“game” the ratings process– Huge financial incentive to keep the game going– Record Revenue

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Rating Agencies – Record RevenueRating Agencies – Record Revenue

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Rating “Shopping”Rating “Shopping”

Issuers would play rating agencies against each other and only use the ones that would provide the highest rating

In an April 2007 instant message chat between two S&P analysts, they acknowledged that the rating process was more about business generation for their employer than it was about getting a quality rating:

Rahul Dilip Shah: btw -- that deal is ridiculous.Shannon Mooney: I know right ... model def does not capture

half of the riskShah: we should not be rating it.Mooney: it could be structured by cows and we would rate it.

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Exemption from the Securities ActExemption from the Securities Act

Issuers and underwriters of securities can be held liable for untrue or false statements and omissions in prospectuses.

SEC regulations provide that “the security rating assigned to a class of debt securities by a[n NRSRO] . . . shall not be considered a part of the registration statement prepared or certified by a person within the meaning of sections 7 and 11 of the Act.” – SEC Rule 436(g), 17 C.F.R. § 230.436(g)(1)– Exempts NRSRO’s from liability for ratings– Bill to revoke the exemption

Did this embolden them? Pursue alternate theories of liability

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It’s Still Happening!It’s Still Happening!

Rating Agencies still issuing inflated ratings

– Eric Kolchinsky: Moody’s continues to issue artificially high ratings

Life Insurance Securitizations

– SEC investigating practices

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ConclusionsConclusions

When gatekeepers fail, investors need to be in a position where policies and practices are independent and transparent– With rating agencies this was a huge

problem– Funds were required/encouraged to

purchase “investment grade” securities– Created an imprimatur of quality/safety

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ConclusionsConclusions

Get independent expert advice

Demand transparency

Responsible parties need to be held accountable

– Lawsuits

– Political Action

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